The Good, Bad, and Ugly

Welcome to “Nerd-vember!” …the month when I “nerd out” for each and every one of our updates on the state of the markets! I’ll let you in on a little secret – I’ve been looking forward to this month since the beginning of the year. For the five Friday’s in November, I’m going to discuss buying strategies, selling strategies, market indicators, and other nerdiness. This week, however, I’m going to kick off Nerdvember with some scenarios from which the stock market could evolve over the next few months – the good, the bad, and the ugly. Alright, let’s go!

Horizontal dashed lines: “Floors” of support based on significant prior lows in the market.

Up/Down (red/black) Arrows: My forward projections of the market for each scenario.

Black straight, dashed lines: Annotations showing the difference between price of the market and momentum

Bottom pane: Momentum as defined by Relative Strength Index (RSI), which looks back 14-days and compares up vs. down days over time.

Now that we have the definitions behind us, let’s get started with the best-case-scenario – or what we’ll call “The Good.”

The market dropped -11.47% on an intra-day basis between September 20th and October 29th, which made it one of the fastest corrections on record. The good news here is that swift corrections like this typically do not happen in a bear market (i.e. – market crash). Rather, they’re just corrections within an overall long-term bull market (long-term uptrend).

One piece of positive evidence so far is the positive divergence in momentum (lower pane) vs. the stock market. Look at the lower-lows in the black-dashed line between October 11th and October 29th. Then notice the higher-lows in momentum in the bottom pane, where I drew another black-dashed line along those rising bottoms. See it? This is what we call “positive divergence,” and since price typically follows momentum (notice I said “typically,” not “always”), this is one positive piece of evidence that we could be at or near the bottom of this correction.

In this scenario, if things play out how I’d like them to, the market re-tests the October 29th lows (first red arrow down) where the red-dashed, horizontal line lies, and then it climbs back above its long-term trend (first blue arrow up). It would then be normal to see it pull-back to that same, long-term trendline (but above it this time – second red arrow down), and then the market would climb back above the Sept 20th all-time highs, right along with momentum in the bottom-pane. Sound good to you? Me too!

So let’s look at a second scenario, below. This one we’ll call “The Bad (but still good)” because it involves a little more pain, but in the end, we still climb back to new all-time highs.

In this scenario, the market can’t hold the October lows and instead, it heads lower to re-test the lows from the first correction this year, back in February. In fact, if you look back to April of this year, you’ll see that the same thing happened then – when the market re-tested the February lows and then headed higher to print new, all-time highs.

So as you can see, in this case, we bounce off those Feb/Apr lows, but notice how momentum (in the bottom pane) continues to print higher/rising lows and this time, the low is above 30, which is traditionally considered bearish (if below that level). This would pretty much complete the positive momentum divergence we’ve been waiting for, should it play out in this manner.

From there, you can see that we could head back above the October lows, pullback, climb above and reclaim the long-term trend, pullback again, and then ultimately climb to all-time highs. Sound good? No one wants the pain in the short-term, but ultimately, I’m okay with this one, too!

Alright, on to the third scenario, which we’ll call “The Ugly” for obvious reasons. The first thing you’ll notice is that the market can’t hold above the October or Feb/April lows. That wouldn’t be good. Nor would it be encouraging if the market tried to bounce back and reclaim those lows, but then fail to do so. At this juncture we’ve already been selling investments we own on rallies in order to reduce risk.

Notice how momentum breaks down in the lower-pane, below the important 30-level, as the next leg down in the market would likely cause the intermediate-term trend to cross below the long-term trend – something that does not happen very often. This would indicate a very “risk-off” environment where we would not want to be even remotely heavily invested in the stock market, if at all. Yeah… no bueno.

The conclusion here is that, regardless of all the remaining evidence that pointed to a possible intermediate-term rally higher, the market just couldn’t make it happen. It could be due to tariff issues, the election, economic indicators, inflation, the Fed, interest rates, geopolitical worries, or a combination of the above. In the end, the “why” doesn’t matter, does it? I’d rather not see this scenario play out, but if it did, by this point, we want to be protecting our capital via exiting the markets for the most part.

While I laid out three possible scenarios for the months that follow, here’s one more possibility – and it’s one that I think is the most likely at the current moment.

Whether we re-test the October lows and bounce or fall back to the Feb/April lows and head higher is truly irrelevant to me. While holding the October lows would be more encouraging than seeing the market down at February levels, the long-term trend is what’s most important to me. So regardless of where the bounce comes, I think we’ll eventually recapture the long-term trend, pullback, and head somewhere close to, if not above all-time highs.

Why do I feel this scenario is most likely? First off, I mentioned in the beginning that we almost never see big, fast, swift corrections during bear markets. So for that reason, alone, the probabilities favor this being a mere correction, and that we won’t likely see a crash develop over the next month or two. Instead, I believe the market is still somewhat oversold (the metaphorical rubber-band has stretched to the negative side) and while we may see some lower movement in the short-term, I think the probabilities are higher that we snap back over the next few months.

Secondly, while it’s beyond the scope of this article, I’m still watching out for a long-term, negative divergence between breadth indicators (fewer participation of stocks during the up-moves) and the stock market. I’m simply not seeing that yet, and it’s important to note that a divergence in breadth against the market has preceded virtually every single market top since The Great Depression. As such, the Sept 20th market highs are likely not the last all-time-highs we’ll see in the months that follow.

Third, November 1st marked the beginning of the “Seasonally Strong” months of the year for the stock market. Seasonality has played a big role in the gains experienced in investor portfolios. Going back to 1950, an exorbitant percentage of the performance realized in the stock market was captured between November 1st and May 1st.

So with these strong months upon us, the fastest part of the correction likely behind us, and the lack of negative divergence in market breadth/participation, it’s likely that the market finds some positive traction before we can start talking about a market crash.

I’d like to see the October lows, or at worst, the Feb/April lows hold, for that bounce to occur shortly thereafter, and for the market to reclaim the long-term trend and head higher. We’ve already turned down the “dimmer switch” and lightened up the risk in our portfolios a little, and depending on what the market does over the coming weeks, we may need to take more risk off the table. No matter the scenario, the market will tell us what to do!

In the end, I would highly encourage you to ignore the market in the short-term. Let the financial advisory firm you hired do the worrying and allow them to make the necessary changes needed as the market landscape changes.

Instead of looking at the market and performance of your portfolio in the midst of a correction this past month, login to your retirement plan and give it a good look.

<If you’re one of our clients and you don’t know your retirement plan login, contact us and we’ll reset your password for you right away!>

When you look at your retirement plan, are you still on track to hitting all your goals? If you’re still working, are you still going to retire when you want to? What’s your personal probability % of making it from now till the day you die without ever running out of money?

These are the things investors should be focused on. We’ll worry about and adapt to the changes in the ever-volatile markets!

I hope you enjoyed the first issue in this five-part “Nerdvember” series! Now turn off the TV, turn off the radio, go for a drive, watch the leaves change, spend time with your friends and family, and enjoy your fun fall weekend!

Till next time…

Adam

The opinions mentioned in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial adviser and strongly consider interviewing a fee-only financial advisory firm, prior to investing. Past performance is not guarantee of future results. Economic forecasts set forth may not develop as predicted. The views and opinions expressed in this commentary are those of Adam D. Koos, CFP® and do not represent the views of TD Ameritrade Institutional and its affiliates. Investing involves risk including loss of principal.